About the return of volatility and predicting the movements of currencies

market watch if

“If you can keep your head when all about you

Are losing theirs and blaming it on you,

If you can trust yourself when all men doubt you,

But make allowance for their doubting too”

I remember the Rudyard Kipling poem ‘IF’ and in particular the first verse above. Indeed we could consider the poem in an ironic sense, it is said that this poem was in fact written with regard to a failed 500 man raid instigated by the Reform Movement and led by a certain Leander Starr Jameson on the Boers in Southern Africa, which is now widely believed to have started the Boer war. (Jameson was later tried and imprisoned in Holloway for his part in the mercenary act). We only have to look at the current climate and the few that led their institutions into a blind and almost dogmatic raid on all things pertaining to credit to apply this same analogy, but possibly in its more literal sense the verse highlights that FX is just the product that will allow you to keep your head, whilst others lose theirs.

Over the course of the next few editions of FX trader Magazine I shall attempt to disseminate as to why FX is indeed a product that may buck the trend of otherwise ‘dysfunctioning’ markets and look at how recent events may shape the FX market and all those that participate in it., but more importantly how some of those that participate in it may actually shape the market itself.

This was borne out of a conversation I had with a gentleman at a social event, a very convivial social event I might add and an event not connected with my work in the city which invariably allows one a certain freedom of speech that in the confines of my environment is often held back. As it turned out this chap held a rather enviable or some may argue unenviable position in charge of a large slice of real money for a rather large UK insurer and it was impressed upon him by his management the need for an alternative approach to investment, notably FX funds. Now this was an interesting declaration on two levels, this particular company is one of those that could be considered to be typical of a traditional UK financial institution in those eyes that would stereotype it as such, including myself. It could be argued that it has a monotone approach to financial services and dare I say a certain type of bland Brutishness. With this in mind and during the present climate, firstly, why would said institution decide to veer from its traditional rather safe course and  secondly, where risk is the word on every bodies lips, why would an institution such as this look to a product that has long been considered leveraged and risky.

Further on in the conversation was probably the very reason that many similar managers have only very recently chosen to look at FX as a product and are now raising these issues. For a while now we have all heard of the Asset class nature afforded to FX and for as long now we have heard the buzzword ‘Alpha’ when considering FX as an investment, but very simply and continuing throughout the conversation the gentleman could not understand how anyone could predict the movement of currencies. It is a very valid and perfectly reasonable question but here is perhaps the problem in a nutshell and on further investigation we may all find out that us as participants in the FX Market are equally to blame for the fact that a large percentage of money held by those large institutions, whether in pension or as an investment vehicle in its own right, choose to apply funds to traditional investments and why FX as an investment option only in times where those traditional investments are not performing

I suspect the question I am asking is how FX can become a natural choice of non correlated investment for the potential investor and how the providers of such fit in to the changing market place in both FX as an investment and FX in its traditional sense. Whilst there are many avenues of inquiry and there is indeed much to dissect, in this first edition lets address the question raised above

How can anyone predict the movement of currencies?

Unfortunately it was not the sort of evening where one could start waxing lyrical about the fact that this was perhaps the wrong question to be asking, but let us understand the primary driver of any currency fund worth its salt,…..risk. It is very easy to enter a position but the talent lies in managing the risk that is inherited from taking that position and as importantly the fact that risk determines the point of entry in most cases. An industry colleague told me that while sitting in front of potential investors to his currency fund, it became apparent to him that the simplicity of the model he employed was lost on seasoned analytical minds from an equity background. To them the argument was that there are fundamentals in the equity markets that one addresses, corporate earnings and therefore dividend yields, which of course directly or indirectly provide two separate investment streams, capital growth and income. Yes the wider markets and public are now accustomed to the demonised hedge fund that sells short the stock and is subsequently blamed most of the time for share prices moving against what are the true fundamentals, but the idea that something as intangible as selling one currency for another or for that matter buying could be working under similar quantative logic as say a long short equity fund, seemed utterly incomprehensible. To then take it a step further and suggest that perhaps the currency markets are somewhat more robust due to the greater and some would argue infinite liquidity seemed to only blur the judgement further.

At the risk of suggesting I spend my every waking moment in the company of FX or currency fund managers, another market colleague of mine highlighted this issue on liquidity further, where he aligned his own currency fund to that of a speed boat in comparison to maybe a large traditional equity fund or money market fund that he suggested as an oil tanker. In the first instance the speed boat can nimbly navigate its way through calmer seas than that of the oil tanker, but should the seas become so choppy that a new course is required the speed boat can act equally as nimbly, re-calibrate its course and take action as necessary, whilst the captain of the tanker is still trying to reach the bridge. It is obvious that any small fund is easier to turn around than any big fund, but in the case of FX unlike many traditional financial product funds, the liquidity of the market is such that there will arguably always be a price. Obviously scalability is an issue, we all know that there is a critical mass to any fund in terms of its performance in regard to assets under management and FX is no different, but the point I suspect my colleague was making is the natural depth of liquidity, (let’s not forget that aside from generating ‘Alpha’ the FX market is essentially a requisite for any cross border business). Consequently the liquidity and price risks that are inherent in other financial product funds are mitigated greatly by the FX markets unique depth.

In order to address this even further, fund of funds that are ubiquitous in more traditional financial markets also exist in the FX Market, the overriding memory of the conversation with the well known insurer was the misunderstanding that a currency only FX fund is the same as the next, you simply take a view on whether the currency goes up or down, which in simplistic terms is of course correct, but like those traditional financial product funds there are many ways to skin a cat. Intraday, high frequency, quantative, discretionary, longer term, carry, arbitrage are some of the titles applied to different models, some apply a number of characteristics in order to delineate and un-correlate even further, but perhaps I am getting a little too technical for myself here The fact is that much like traditional products there are different methodologies in creating ‘alpha’. And much like a fund of fund manager so there are multi manager funds in the FX market. This was somewhat of a revelation for a person who in their own admission, had not really paid much attention to FX .

What about volatility?

One may argue that this is only the friend of the Broker-dealer or liquidity provider and of course it is, but on anecdotal evidence many of the currency only funds have mentioned that during the last 12-18 months they have been spoilt, and again whilst not scientific or in anyway proven statistics, they (in my environment) have posted some of the best yearly performance in their history, again like anything there are good and bad,  but as we mentioned before any fund worth its salt addresses risk and in these markets that same logic whether employed discretionally or quantatively, one might argue, is far more robust in its application than, say, a traditional financial market product that has been one sided in its movement in recent history.

The ‘return of volatility’ as it has been labelled by a colleague reminds me of a conversation I had with one of the few FX only funds that existed in the hallowed  streets of Mayfair many moons ago, who on the inception of the EUR, his discretionary fund, he suggested, had less chance of improving yearly performance, as it was argued that at the time of the conversation, there were then only maybe 6 real moves in the majors during the year. If we look at the benchmark 3 month historical volatility in say EUR/USD today, it has increased considerably. After September 2008 and the real shocks of banks collapsing it rose from just over 10% to 24% in the proceeding quarter, and the other majors produced similar notable increases.

So evidently there is truth in the volatility argument, and the fact that perhaps no one could actually predict the movement of currencies, perhaps the idea of funds that are leveraged also increases that insecurity further, but perhaps we as participants in the FX markets are simply fulfilling our own prophecies of being the less glamorous asset class. Perhaps we unconsciously cultivate the myth that we work in a market that is the domain of a certain breed of character. Or perhaps we actually work within a market that in the present climate needs a re-branding, unlike exchange traded products we have no central face that will do this for us, an OTC market is naturally fractured in its message and therefore its service, Perhaps all of ‘us’ Broker Dealers and Liquidity providers need to work together more closely.. After all as a product in its own right there is none that is more transparent in its mechanics or less credit intensive than a simple spot foreign exchange deal. Maybe it is not necessarily the product that is the problem but the lack of transparency in the market itself and again the fractured nature of it but as they say, this is another conversation. So perhaps it is time that the FX market grew up a little, which leaves me reciting the final 2 lines of that same Rudyard Kipling Poem:

“Yours is the Earth and everything that’s in it,

And - which is more - you’ll be a Man my son!”

Ben Brown